Are you thinking about starting or buying a business? Do you currently operate a business as a sole proprietorship? One of many things to consider is how to protect yourself and your family from the financial risks associated with operating the business. The way a business owner addresses this issue could mean the difference between financial security and exposing his or her personal, non-business assets to devastating losses.
There are several ways business owners can protect their personal assets. The primary way should be to obtain insurance coverage (e.g., property, liability, and errors and omissions insurance). Business owners should carefully consider with their insurance agent the appropriate type and amount of insurance coverage for the business being operated. However, because circumstances may arise where there is not enough or no insurance coverage at all for a particular liability, business owners also should consider creating a business entity to operate the business, such as a limited liability company or a corporation.
A critical feature of using a business entity is that, if such an entity is created and operated correctly, all liability of the business remains trapped in the entity, thereby preventing the business owner’s other personal assets from exposure to the business’ liabilities. To say it another way, a creditor of the entity may not pursue an owner’s personal assets to satisfy an entity obligation. Note, however, that the business owner must observe formalities in operating the entity and otherwise treat it as separate from the owner’s other financial affairs.
As an example, assume that Sally operates a flower shop as a sole proprietorship. What might happen if Sally negligently caused an accident during a delivery, which resulted in the other driver incurring $800,000 in medicals bills, but Sally only had a $250,000 liability insurance policy? Sally’s insurance would likely pay the limits of the policy, leaving Sally personally exposed to another $550,000 of liability. Sally would likely have to use her other personal assets to pay the remaining bills, and if she does not have enough assets to do so, she may need to file for personal bankruptcy. In this example, had Sally formed an entity to own and operate her business, then, after applying the limits of the insurance policy, the other driver could only pursue the other assets owned by the entity. The other driver could not pursue Sally’s personal assets, even if the entity did not own enough other assets to pay the remaining $550,000.
Forming an entity can be a fairly quick process and cost a relatively modest sum, often less than $1,000. Formation of an entity in Nebraska generally requires (1) the filing with the Secretary of State of a short document containing information about the entity, and (2) a document that governs how the entity will operate. There are, however, other considerations when choosing the type of entity to create, such as payroll and income tax matters.
Operating a business through a business entity can be a prudent way to help ensure that the personal assets of a business owner are protected from the creditors of the business. If you own a business as a sole proprietorship, consider consulting with an attorney about the advantages of forming an entity to determine if this is a wise decision for you.